Perspectives on Sustainability of Financial Institutions In Financial Crises

Current Regulatory Approach Adds Risks to Banks

By Karamjeet Paul

Recent proposals to increase the bank capital requirement to 15% amount to kicking the can down the road.

Why 15%? After all, if the solution is so simple then why not raise it to 50% to make banks super safe? The 15% requirement is just as arbitrary as any other subjective figure that can be brought to the table. Instead, regulators should address the fundamental issue that creates the need for capital in the first place, and help us truly postpone our next day of reckoning.

Capital serves a critical function. Managed properly, it supports growth by cushioning exposure from unexpected hits that may otherwise discourage prudent risk taking. Without this focus, stricter capital regulations not only avoid the real issue. They actually add three new risks.

First, while regulations are essential for an orderly system, regulatory reform is a vicious cycle if the real problem is not addressed. Institutions often respond to new regulations to control “too much risk” with new complex products that purposely skirt the regulations to protect their interests. This adds new risks, which the complexities make difficult to recognize and come to light only when the next disaster strikes (think CDOs, VIEs, swaps, etc. and their pre-2008 veiled risk). More regulations are then introduced to fix this problem and the cycle starts again with complexities and risks compounding over time.

An example: The 30-page Basel I, followed by the 347-page Basel II, followed by the difficult-to-comprehend 1,000-page Basel III, each expanded to cover risks from new products after the previous guidelines added restrictions. And yet no one is certain that the fundamental problem has been licked. What’s next? A 2,000-page Basel IV?

Second, the lack of focus on the root of the problem risks making banks unwitting victims of “too much risk.” Today’s increased regulatory and political concerns require dotting all i’s and crossing all t’s, distracting the finite attention of senior management from what really causes havoc in crises. An example: The unwitting surprise of the London Whale. In another time, at another place this could be ugly (think MF Global). How much risk from other London Whales is lurking around unwittingly?

Third, merely relying on regulatory capital requirements to ensure sustainability can leave banks vulnerable in crisis. The obsession with regulatory capital distracts from a critical issue: how much capital is needed to provide a prudent return to investors and ensure sustainability of institutions through crises in the marketplace?

No failed bank was ever declared capital-deficient prior to its collapse. For example, pre-2008, Tier 1 capital ratios of WaMu (6.84%) and Wachovia (7.35%) exceeded the 6% requirement. Even Citi with a 7.12% ratio struggled to survive. Relying solely on regulatory requirements adds risk by leaving unaddressed what really leads to bank failures.

Banks fail for a fundamental reason. Financial investing is based upon the theory of probability. Therefore, actual results may be favorable or unfavorable versus expectations. Unfavorable results fall into two categories. They can fall short because of the expected everyday ups and downs (“normal risk”). Revenues from other transactions cover such shortfalls/losses. Or they can be massively off because of unexpected events (“tail risk”), and the shortfalls/losses exceeding revenues from all transactions must be absorbed by capital. In an extreme situation, such losses can exceed total capital. When they do, the bank fails.

There is no relationship between expected losses from “normal risk” and the maximum potential losses from “tail risk,” as these are two independent factors. Both must be managed simultaneously and distinctly as they impact institutions very differently. Cost of being wrong in relation to normal risk is the loss of profits; the cost of being wrong with extreme-tail risk can be fatal to institutions. For this reason, managing extreme risk as an extension of normal risk is a disaster waiting to happen (think Bear Stearns and Lehman).

What caused failures in 2008 was not “too much risk,” but too much extreme-tail risk – a critical distinction. While recent actions have targeted “too much risk,” none has fully addressed the extreme-risk vulnerability. Actually, today there is not even any metrics to measure it, without which one can’t objectively address how much extreme risk is too much or how much capital is needed to protect against it.

Bank failures in a crisis always come as a surprise because, without a measure, even the management doesn’t know how close to the edge of extreme-risk precipice their institution is, and thus remains unaware of their vulnerability (think London Whale in a different setting).

Stress testing, a step in the right direction, needs to go farther and must overcome 3 objections. One, because it doesn’t address the fundamental problem, it will be gamed adding new risks that will come to light next time around. Two, its subjective assumptions leave it vulnerable to the surprises of the next crisis. Three, without transparent objective metrics, it can’t be institutionalized in a bank’s management process.

Financial crises are part of economic cycles and will happen again. The only sure way to survive them is to grasp extreme risk now and manage it proactively. Banks have precise metrics for profits and volatility from normal risk. Shouldn’t there be one for extreme risk that causes devastations in financial crises?

Capital guidelines based upon objective and transparent metrics of extreme risk will fundamentally address the risk to financial institutions’ sustainability in crises and thus strengthen the financial system. Anything less leaves the problem unaddressed, with the real culprit lurking around unwittingly at best and compounding risks over time at worst.